Energy Commodities: The Netherworld Between FERC And CFTC Jurisdiction

Article by Terence T. Healey , Joseph B. Williams and Paul J. Pantano, Jr. ¹

INTRODUCTION

Midway upon the journey of our life I found myself within a forest dark, For the straightforward pathway had been lost.²

In 1999, we wrote an article about managing legal risk in the electric power market, which at the time was a new competitive wholesale commodity market subject primarily to the jurisdiction of the Federal Energy Regulatory Commission ("FERC"). A lot has happened in the energy commodity markets and the regulatory environment since 1999. It would be hard, however, to describe intervening events as progress, particularly when it comes to the "lines" between FERC and Commodity Futures Trading Commission ("CFTC") jurisdiction. This article describes the evolution in the regulation of the energy markets from 1999 to the framework that exists today.

As the great philosopher, Yogi Berra, once said: "This is like déjà vu all over again." In 1999, lawyers and market participants spent a fair amount of time worrying about whether electricity and natural gas forward contracts with embedded bells and whistles were really forward contracts, excluded from the CFTC's jurisdiction and, possibly, within the FERC's jurisdiction, or instead were illegal off-exchange futures contracts, squarely within the CFTC's jurisdiction and surely not within the FERC's jurisdiction. Commodity options raised similar transaction characterization issues. Then, in 2000, we achieved legal Nirvana: Congress passed the Commodity Futures Modernization Act ("CFMA"). The industry no longer had to worry about whether contracts between sophisticated commercial parties had attributes that converted them, metaphysically, from lawful forward contracts into illegal futures contracts. Lawyers were able to spend their time on more productive activities, such as getting deals done, or resolving industry-wide disputes, such as those following the California energy crisis.

In 2010, Congress decided that commodity and derivatives lawyers had spent too much time in legal Nirvana. Instead, Congress determined that lawyers should descend into nine levels of legal hell. And, while Congress debated the Dodd- Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"), the FERC and CFTC engaged in hand-to-hand combat over the "lines" between their respective jurisdictions. They both lost. In the true spirit of regulatory bipartisanship, Congress punted—drawing clear lines is not its specialty. Instead, Congress resorted to jurisdictional savings clauses and exemptive authority, and it told the agencies and market participants to duke it out in the regulatory arena.

In a statute with no definition of futures contract or forward contract, Congress added a six-part (with 22 subparts) definition of swap. The definition is so broad that almost every possible energy contract that is settled in cash, rather than with a physical delivery, arguably is a swap. Congress also introduced the subjective concept of "intent" to physically settle into commercial contracts (forwards and options) that already have binding delivery obligations. Not to be outdone by Congress, the FERC in an important administrative decision added an intent element to the determination of whether electricity transactions are within the scope of its jurisdiction. And the CFTC, not to be outdone by either Congress or the FERC, has introduced multiple tests (some with three, five and seven parts!) for determining whether commodity transactions of all types are in, half in, or out of its jurisdiction. All of these legal brain teasers are enough to make an energy lawyer nostalgic for the "painful" days before the CFMA. When descending into the nine circles of legal hell, all pain is relative.

In our 1999 article, we mentioned the transformation of the wholesale electric power market from a heavily regulated market into a competitive one.³ What we have learned in the intervening 14 years is that the regulatory maze faced by the industry has become much more, not less, complex. Regrettably, market participants face more legal and regulatory risk than ever. This article updates the discussion of legal and regulatory risks faced by industry participants.

FENCING OVER JURISDICTION CONTINUES

Both physical and financial transactions in the wholesale power and gas industries are the subject of considerable regulation by the CFTC and FERC—and sometimes both. Congress has not alleviated the legal headaches that market participants and the legal community face from the CFTC's and FERC's sometimes overlapping jurisdiction (and the agencies' differing views of their jurisdiction).

CFTC Jurisdiction

The CFTC has "exclusive" jurisdiction over "accounts, agreements (including ... options) ... and transactions involving swaps or contracts of sale of a commodity for future delivery."⁴ To be legal and enforceable, futures contracts must be traded on a commodity exchange that has been designated as a contract market ("DCM") by the CFTC.⁵ Under the Commodity Exchange Act ("CEA"), as amended by the Dodd-Frank Act, swaps subject to mandatory clearing must be traded on a swap execution facility ("SEF") or a DCM. Swaps used by a company to manage the commercial risks associated with its business are exempt from the mandatory clearing requirement and may be executed bilaterally in the over-the-counter ("OTC") market.

The CEA does not define the elements of a "futures contract." Nevertheless, to ensure that the CEA does not apply to commercial contracts for the delivery of a commodity, the CEA provides that the "term 'future delivery' does not include any sale of any cash commodity for deferred shipment or delivery."⁶ Such deferred delivery or "forward contracts" are excluded from the provisions of the CEA and the CFTC's regulations. Ironically, even though the CEA, as amended by the Dodd-Frank Act, still does not define a "futures contract," it now contains a six-prong definition (with multiple subparts) of "swap." Similar, but not identical, to the exclusion from "future delivery," Congress excluded from the term "swap" "any sale of a nonfinancial commodity . . . for deferred shipment or delivery, so long as the transaction is intended to be physically settled."⁷ More on this topic later.

"Spot" or "cash" contracts for the immediate sale and delivery of a commodity also are outside of the CFTC's jurisdiction.⁸ The CFTC defines the spot or cash market for a commodity by reference to commercial practices in the market for that commodity.⁹ Options "involving any commodity regulated" under the CEA, which previously could only be offered and sold in accordance with the terms and conditions in the CFTC's options regulations, now are subject to the same regulations as swaps except for "trade options," which generally are OTC commodity options offered to commercial parties for hedging or inventory management purposes that, if exercised, are intended to be physically settled.¹⁰

FERC Jurisdiction

The FERC is an independent regulatory agency within the Department of Energy.¹¹ Under the Federal Power Act ("FPA"), the FERC has jurisdiction over the interstate transmission of electric energy and the interstate sale of electric energy at wholesale, i.e., the sale of power to any person for resale.¹² The FERC's authority includes "the establishment, review, and enforcement of rates and charges for the transmission and sale of electric energy ... and the interconnection of facilities for the generation, transmission, and sale of electric energy."¹³ The FERC has jurisdiction over all facilities for the transmission and sale of electricity in interstate commerce. The FERC is also responsible for overseeing the reliability of the nation's electricity transmission grid.¹⁴ In addition, the FERC reviews and, in certain cases must approve, various corporate activities and transactions by public utilities, such as mergers, securities issuances and interlocking directorates.¹⁵

All public utilities must file with the FERC schedules of their rates and charges for the interstate transmission and wholesale sale of electricity. ¹⁶ Those rates and charges must be "just and reasonable."¹⁷ Any rate or charge that is not just and reasonable is unlawful.¹⁸ In addition, the rates and charges of public utilities for services within the FERC's jurisdiction must not give undue preference to any person, or unreasonably discriminate between classes of service.¹⁹

In New York Mercantile Exchange, the FERC disclaimed rate jurisdiction over an electricity futures contract unless it results in physical delivery.²⁰ Interestingly, the FERC reserved decision on whether it had "jurisdiction over other types of risk management instruments; e.g., options contracts, forwards contracts, or swap agreements."²¹ In Puget Sound Energy, Inc., a FERC administrative law judge reasoned that because book-out transactions do not result in the physical delivery of electricity, such transactions are "... not subject to the Federal Power Act in the first instance."²² The FERC did not address that particular ALJ decision.²³ In a later, unrelated order, the FERC declined to address whether the transactions underlying book-outs are in fact jurisdictional.²⁴ It did, however, order public utilities to report book-outs of any power sales contracts that provide for physical delivery but not "purely financial transactions."²⁵ In a more recent case, DC Energy, LLC v. PJM, the FERC determined that DC Energy's transactions with an affiliate that were documented with an ISDA (with power annex) constituted a financial transaction and, therefore, did not satisfy a PJM tariff provision requiring that internal bilateral transactions "contemplate[] the physical transfer of energy."²⁶ In a finding that tracks the forward contract exclusion from the definition of swap under the CEA, the FERC concluded that DC Energy had no way to physically deliver electricity and, instead, intended for the transactions to settle financially.²⁷ Not surprisingly, in its rehearing request DC Energy pointed out that the FERC's holding leads to the conclusion that the FERC lacks jurisdiction over the transactions and that they would, instead, be swaps regulated by the CFTC.²⁸

In addition, as a result of the Energy Policy Act of 2005 ("EPAct 2005"), the FERC now has express anti-manipulation authority that allows the FERC to address activity "in connection with" a FERC-jurisdictional transaction.²⁹ And the water starts to muddy.

Exclusive Jurisdiction?

Following passage of the Dodd-Frank Act, it is unclear whether the CFTC's jurisdiction over all electricity and natural gas swaps and options (a subset of swaps) is really "exclusive." During the negotiations leading to the enactment of the Dodd-Frank Act, both the CFTC and the FERC sought to have Congress draw bright lines between their respective jurisdictions. The FERC, in particular, wanted Congress to exclude from the CFTC's jurisdiction transactions in markets administered by FERC-authorized regional transmission organizations ("RTOs") and independent system operators ("ISOs"). Rather than drawing bright lines, Congress instead included savings clauses and additional exemptive authority which, if anything, muddied the distinctions between the authority of the two agencies.

Section 2(a)(1)(i) of the CEA states that:

This provision appears to preserve the FERC's jurisdiction over wholesale electricity sales and certain natural gas transactions (i.e., those that are not "first sales"). It does not, however, limit the CFTC's jurisdiction over the same transactions. The very next clause, Section 2(a)(1)(ii), states that:

When read together, these provisions indicate that Congress did not limit either agency's authority over what it already regulated, but also did not appear to expand either agency's pre-existing authority. Instead, these provisions appear to contemplate that there may be some transactions over which both agencies have jurisdiction. As a result, market participants and legal practitioners are left to figure out where the jurisdictions of the FERC and CFTC overlap and try to predict what how the agencies are going to approach the areas of regulatory overlap. Congress did provide, however, a means to exempt certain FERC-jurisdictional transactions from the CFTC's jurisdiction.

In Section 4(c) of the CEA, Congress amended the CFTC's authority to allow it to exempt certain transactions made pursuant to FERC, State or municipality-approved tariffs from part or all of the CFTC's jurisdiction provided that certain conditions are met, i.e., the exemption must be in the "public interest" and must not adversely affect the ability of the CFTC and DCMs to perform their regulatory functions, and the transactions must be entered into by "appropriate persons." The CFTC also has the authority to exempt from its jurisdiction the operators of markets on which such transactions are traded, the services they provide and the persons who enter into those transactions.

Recognizing the opportunity to be exempt (at least in part) from CFTC regulation, RTOs and ISOs pursued this relief. Their efforts, however, became intertwined with FERC-mandated credit reforms in the ISO/RTO-administered electricity markets.

Intersection of Exemptive Relief and Credit Reforms

Because utilities historically did not operate in competitive markets, many of them did not have well-developed internal risk management controls. By way of illustration, the FERC Staff noted in 1998 that many market participants traded power based upon poorly drafted contracts and were often are unaware of, or did not understand, the specific terms included in or missing from their contracts.³⁰ Risk management has improved markedly during the past 14 years with the influx of market participants with increased risk management expertise, the development of industry standard master agreements, and FERC-required uniform enhancements to the existing RTO/ISO credit policies and market participant qualification standards through FERC Order No. 741 ("Credit Reform Order").³¹

The credit reforms impacted the electricity products and services that RTOs/ISOs make available to their members. The ISO/RTOs perform a settlement function for transactions in the markets they administer. Entities transact in these markets pursuant a FERC-approved tariff, which contains the applicable terms and conditions of transacting in the relevant RTO/ISO market. In each ISO/RTO market, if one member defaults on payment to the RTO/ISO, then uncollected amounts are mutualized among all other market participants. The RTOs/ISOs have worked sporadically over the years—often in reaction to large defaults—to tighten their respective credit requirements in order to, among other things, mitigate the risk of future socialized defaults. For example, PJM instituted comprehensive reforms to credit policies governing the trading of certain financial hedging products following a major default by one of its market participant members.

Through its Credit Reform Order in 2010, the FERC tried to harmonize key underpinnings of ISO/RTO credit policies and implement mandatory minimum participation requirements in all organized markets. These reforms included a requirement that all participants implement documented risk management policies, which are subject to verification and approval by the RTOs/ISOs under certain circumstances. It also may be the case that the FERC sought to preempt requirements that the CFTC might try to impose on RTOs/ISOs that, now in some cases and soon will in all cases, act as central counterparties and clearing organizations for financially-settled transactions, such as financial transmission rights and virtual transactions.

While the FERC was finalizing and implementing its Credit Reform Order, the RTOs/ISOs were in the process of discussing a possible exemption from the CFTC's jurisdiction for their markets, products and services, and participants. On February 7, 2012, the RTOs/ISOs filed a petition with the CFTC for exemption from all provisions of the CEA, other than the antifraud and anti-manipulation provisions, for the RTOs/ISOs, electricity products and services offered pursuant to their FERC- or PUCT-approved tariffs or protocols, and their members.³² Although the CFTC and FERC so far have avoided a public clash about which agency has jurisdiction over the RTOs/ISOs, the linkage between better risk management controls for those participating in the FERC-regulated electricity markets and the requirements for obtaining an exemption from CFTC regulation became clear.

BRIGHT LINES FOR ENFORCEMENT ACTIONS?

One area of potentially overlapping authority for the CFTC and FERC are their regulations that prohibit manipulation. This is because Congress provided both the CFTC and FERC with expanded anti-manipulation authority in the past several years patterned after the Securities and Exchange Commission's anti-manipulation authority.

FERC's Enforcement Authority

Through EPAct 2005, Congress dramatically changed the FERC's enforcement and civil penalty authority to address manipulative conduct and deceptive practices in the wholesale electricity and natural gas markets. Prior to EPAct 2005, the FERC's enforcement authority was relatively limited, a fact the FERC voiced loudly to Congress in the wake of the Enron experience. Congress amended the Natural Gas Act and the FPA in Sections 315 and 1283 of EPAct 2005, respectively, in a virtually identical manner to prohibit the use or employment of manipulative or deceptive devices in connection with the purchase or sale of natural gas, electric energy, or transportation/ transmission services subject to FERC's jurisdiction.³³ As codified in FERC's regulations, it is unlawful for any entity, directly or indirectly, in connection with the purchase or sale of electric energy or natural gas or the purchase or sale of transmission or transportation services subject to FERC's jurisdiction:

1. To defraud using any device, scheme or artifice (i.e. intentional or reckless conduct);
2. To make any untrue statement of material fact or omit a material fact; or
3. To engage in any act, practice or course of business that operates or would operate as a fraud or deceit.³⁴

In its order implementing the anti-manipulation regulations, the FERC took an expansive view of its new authority. First, it defined fraud broadly to include "any action, transaction or conspiracy for the purpose of impairing, obstructing or defeating a well-functioning market."³⁵ Second, the FERC noted that the "in connection with" language derives from Rule 10b-5, which FERC believes has been construed liberally.³⁶ Although the FERC explained that it will not apply its anti-manipulation rule "so broadly as to convert every common law fraud that happens to touch a jurisdictional transaction into a violation ...."³⁷ it considers a transaction to be covered if "in committing fraud, the entity ... intended to affect, or have acted recklessly to affect, a [FERC-]jurisdictional transaction."³⁸ Accordingly, the FERC considers manipulative conduct as within the scope of its anti-manipulation regulations as long as there is a "nexus" between the conduct and a FERC-jurisdictional transaction.

CFTC's Enforcement Authority

The CFTC has long-held anti-manipulation enforcement authority, but Congress significantly modified the scope of the CFTC's anti-manipulation authority in the Dodd-Frank Act. Section 753 of the Dodd-Frank Act amended section 6(c) of the CEA to prohibit manipulation and fraud in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity. This expanded the CFTC's enforcement reach by enabling it to pursue fraud-based manipulation. This new authority does not include an express requirement for the CFTC to show that the alleged activity caused an artificial price, an element of proof that has been a stubborn challenge for the Commission (and has led to the CFTC primarily making allegations of attempted manipulation). The CFTC also maintains that the scienter requirement for fraud-based manipulation can be satisfied through a showing of recklessness—as opposed to the "specific intent" that was previously required. The Dodd-Frank Act also adds a special provision for manipulation conducted through false reporting, and makes it unlawful to provide materially false information to the CFTC. The new provisions largely replicate similar fraud-based manipulation standards put in place by other agencies, including the FERC and the Federal Trade Commission (each derived in part from section 10(b) of the Securities Exchange Act of 1934).

By expanding the enforcement authority of both the CFTC and FERC, Congress created significant enforcement risk overlap for market participants, but the two commissions have not resolved how to apply their respective authorities. EPAct 2005 required the FERC and CFTC to execute a Memorandum of Understanding ("MOU") to provide for information sharing and better coordination of investigations pertaining to markets within the respective jurisdiction of each agency.³⁹

On October 12, 2005, the FERC and CFTC executed and entered into the MOU.⁴⁰ More recently, in Section 720(a)(1) of the Dodd-Frank Act, Congress mandated that the two commissions enter into another MOU. This MOU was supposed to outline how the two would apply "their respective authorities in a manner so as to ensure effective and efficient regulation," "resolve conflicts concerning overlapping jurisdiction," and avoid "to the extent possible, conflicting or duplicative regulation." The CFTC and FERC never reached agreement. Despite the January 2011 deadline, the MOU has not been executed and apparently remains a work in process (if the agencies are even still discussing it) with no apparent end.⁴¹ Where does this leave us?

Although the CFTC generally does not have jurisdiction over cash market transactions, it has jurisdiction to investigate and prosecute alleged manipulations of the cash price of a commodity.⁴² In addition, the CFTC can compel persons to produce information about cash market transactions in connection with an investigation or prosecution of an alleged manipulation of the price of a cash commodity, futures contract, or swap.⁴³ This provides the CFTC with the authority to investigate wholesale natural gas and electricity markets (including those administered by FERC-regulated ISOs/RTOs). For its part, FERC has jurisdiction to pursue manipulation claims in the wholesale physical natural gas and electricity markets, but it also has pursued claims in related financial products using its "in connection with" authority.

Amaranth/Hunter: Dueling Enforcement Actions

A prime example of the jurisdictional overlap between the CFTC's and FERC's enforcement activities is the case of Amaranth Advisors, LLC ("Amaranth"), where both agencies launched enforcement actions against Amaranth and its natural gas trader, Brian Hunter, based upon the same allegedly wrongful conduct. The CFTC filed a civil enforcement action against Amaranth and Hunter on July 25, 2007, alleging that Hunter "dumped" large amounts of natural gas futures contracts on NYMEX during the last 30 minutes of trading in order to depress settlement prices, thereby benefiting considerably larger short positions Amaranth held that settled against the NYMEX price.⁴⁴ In short, for every dollar Amaranth lost on the sales of its natural gas futures contracts, Amaranth would gain several dollars on its short swap positions. One day later on July 26, 2007, the FERC issued an Order to Show Cause against Amaranth and certain traders, including Hunter, based on the same conduct.⁴⁵

While acknowledging that it does not have jurisdiction to regulate the trading of natural gas futures contracts—a role reserved to the CFTC—the FERC staked its jurisdictional claim on the premise that Amaranth's alleged manipulative conduct "affected" a significant number of FERC-jurisdictional natural gas transactions that were priced on the NYMEX settlement price, and therefore violated FERC's anti-manipulation rule.⁴⁶ In subsequent orders, the FERC rejected arguments that it lacked jurisdiction because the CEA conferred exclusive jurisdiction on the CFTC with respect to futures trades on the NYMEX. The FERC considered the CFTC's exclusive jurisdiction as applying only to the "day-to-day" aspects of futures trading, but not manipulative conduct. Instead, the FERC determined that section 315 of the FPA (added by EPAct 2005) empowered it to reach non-jurisdictional transactions so long as those transactions affected transactions within its traditional jurisdiction. Following an evidentiary hearing, a FERC administrative law judge determined that the FERC's Office of Enforcement had proven the alleged violations against Hunter. The FERC then affirmed the ALJ's initial decision, but did not address further Hunter's argument that the FERC lacked jurisdiction over the natural gas futures contracts at issue.

Hunter appealed FERC's order to the DC Circuit Court of Appeals, claiming that the FERC lacked jurisdiction over the natural gas future trades underlying the FERC's manipulation case.⁴⁷ The CFTC intervened solely for the purpose of briefing the jurisdictional issue, arguing that Congress clearly conferred exclusive jurisdiction on the CFTC, and that Section 2(a)(1)(A) of the CEA expressly provides that the authority of other federal agencies such as the FERC, is superseded. The CFTC also argued that EPAct 2005 did nothing to diminish the CFTC's exclusive jurisdiction. In an opinion for the court by Circuit Judge David S. Tatel, the court held categorically that "[b]ecause manipulation of natural gas futures contracts falls within the CFTC's exclusive jurisdiction and because nothing in the Energy Policy Act clearly and manifestly repeals the CFTC's exclusive jurisdiction," the FERC lacked jurisdiction to prosecute Hunter.⁴⁸ The court's decision is very broad and may severely constrain FERC's ability to prosecute alleged manipulations of transactions subject to the CFTC's exclusive jurisdiction even if the alleged manipulation affects FERC-jurisdictional markets.

Based upon its analysis of the statutory text, the court concluded that "[b]y CEA section 2(a)(1) (A)'s plain terms, the CFTC has exclusive jurisdiction over the manipulation of natural gas futures contracts."⁴⁹ According to the court, "the CFTC's jurisdiction is exclusive with regards to accounts, agreements, and transactions involving commodity futures contracts on CFTC-regulated exchanges."⁵⁰ As a consequence, "if a scheme, such as manipulation, involves buying or selling commodity futures contracts, CEA section 2(a) (1)(A) vests the CFTC with jurisdiction to the exclusion of other agencies."⁵¹ Elaborating on this point in a comment with incredibly broad implications, the court explained that "once a scheme crosses the statute's event horizon, the CFTC has exclusive jurisdiction."⁵²

Keep in mind that the facts in Hunter predate the amendments to the CEA made by the Dodd- Frank Act. As we pointed out above, the CFTC now has exclusive jurisdiction over futures and options on futures transactions, and commodity swap transactions traded or executed on a CFTC-regulated contract market (exchange), swap execution facility, or "any other . . . market." Thus, if an alleged manipulative scheme involves any of the following types of transactions and, "crosses the statute's event horizon," then FERC arguably lacks jurisdiction to prosecute the alleged manipulative conduct even if it is "in connection with" a FERC-jurisdictional transaction:

• Commodity futures contracts and options on futures contracts;
• Commodity options;
• Commodity swaps;
• Financial transmission rights;⁵³
• Day-ahead transactions;
• Virtual transactions;
• Internal bilateral transactions;
• Demand response transactions.

The next time when the FERC considers bringing an action against a company that does not trade FERC-jurisdictional transactions, perhaps it should consider the potential unintended consequences of seeking to broaden its jurisdictional reach. Now, not only will the Hunter decision limit future enforcement actions by the FERC, it potentially will adversely affect pending investigations that involve transactions subject to the CFTC's exclusive jurisdiction.

Given the agencies' expansive views of their respective jurisdictions, and the large number of market participants participating in both physical and financial products, it is possible that we will continue to see examples of overlapping enforcement actions by the CFTC and FERC. It is difficult to predict whether the two commissions will apply their respective anti-manipulation authority in a manner that will yield consistent results. As the Amaranth/Hunter cases show, both of them can be interested in the same conduct. Hopefully, the agencies will find a responsible and practical solution to ease concerns in the marketplace. Enforcement jurisdiction is not, however, the only area of ambiguity and conflict in the jurisdictions of the two agencies. The CFTC's and FERC's differing and sometimes overlapping jurisdiction over certain products and services remains an issue after passage of the Dodd-Frank Act.

PHYSICAL, FUTURES, AND SWAPS TRANSACTIONS

As was true in 1999, the wholesale power and natural gas markets remain subject to extensive federal regulation. Because electricity and natural gas are commodities, certain electric power and natural gas transactions, such as futures contracts, swaps, and options (now a sub-set of swaps) fall within the CFTC's jurisdiction.⁵⁴ Those transactions must comply with the CEA and the CFTC's regulations to be legal and enforceable. As we noted in 1999, because electricity and natural gas are traded in a competitive wholesale commodity markets, there are areas where the CFTC's and the FERC's jurisdiction overlap. This overlap, which was exacerbated by passage of the Dodd- Frank Act, creates additional legal risks that must be managed by industry participants.

In addition to improved credit and risk management practices, the manner in which transactions are documented has also become much more standardized since 1999. Several master agreements (and related annexes) are staple documents governing bilateral trading in the wholesale electricity and natural gas trading markets. These agreements generally set forth the procedures parties will follow in entering individual forward transactions. They also contain important commercial and credit terms that will apply to all transactions between the parties such as delivery procedures, billing, payment and netting, representations and warranties, events of default, termination procedures, and other standard contract terms. These agreements brought much needed standardization, thereby reducing documentation and credit risk in the markets. Industry groups, such as the International Swaps and Derivatives Association ("ISDA") and the Edison Electric Institute ("EEI"), remain nimble and continue to modify industry agreements to address market and regulatory developments, including the addition of new products (e.g., renewable energy credits).⁵⁵

NOW, WHAT'S IN, SORT OF IN, AND OUT OF THE CFTC'S JURISDICTION?

Electric Power and Natural Gas Forward Contracts

As we noted in the 1999 article, the FERC Staff Report in 1998 described an electric power forward contract as "a contract for future delivery of a designated quantity of power at a designated price, time and location."⁵⁶ An analogous description would apply equally to natural gas forward contracts. Although forward contracts are excluded from the CEA's jurisdiction, there is no bright line distinction between a lawful "deferred delivery" contract and a swap or an illegal off-exchange futures contract.

The most significant distinction between a forward contract and either a futures or swap contract is that forward contracts by their terms require physical delivery of the underlying commodity while futures contracts and swaps by their terms can be settled for cash without making or taking delivery. A wholesale power or natural gas sale contract styled as a forward, but which arguably is not intended to settle physically, is at risk of being challenged by the CFTC (or an out-of-the-money counterparty) as a swap or an illegal futures contract.⁵⁷ To ensure that their contracts are enforceable and to avoid the adverse consequences of a CFTC investigation, power and natural gas market participants need to be familiar with the scope of the forward contract exclusion from the CFTC's jurisdiction over swaps and futures contracts.⁵⁸

In its final regulation further defining the term "swap," the CFTC provided market participants with good news and bad news. The bad news: the CFTC appears to have narrowed the scope of persons who are eligible to enter into excluded forward contracts and has introduced a number of new, commercially impractical tests for determining when an embedded option changes the character of a contract from a forward contract into an option or swap.

First, the good news. The CFTC will continue to interpret the forward contract exclusion from "future delivery" and "swap" consistently with its 1990 Statutory Interpretation Concerning Forward Contracts (the so-called "Brent Interpretation").⁵⁹ Contracts between commercial market participants for the deferred shipment or delivery of a non-financial commodity that are intended to be physically-settled are excluded from the CFTC's jurisdiction. The CFTC interpreted the term "nonfinancial commodity," which is included but not defined in the CEA, coextensively with the term "exempt commodity." In essence, any commodity that can be physically delivered—agricultural, energy, and metals commodities, and intangible contract rights that meet certain conditions (e.g., so-called environmental commodities such as renewable energy credits)—is a nonfinancial commodity.⁶⁰ The CFTC withdrew its 1993 Energy Contract Exemption, which technically applied to a limited number of commodities, but retained a number of helpful aspects of the exemption in the forward contract interpretation.⁶¹

Now, the not-so-good news. Only "commercial market participants that regularly make or take delivery of the referenced commodity in the ordinary course of their business" are eligible for the forward contract exclusion.⁶² According to the CFTC, commercial market participants are producers, processors, fabricators, refiners and merchandisers of the underlying commodity.⁶³ Notably, this list does not include commercial users of commodities. Nevertheless, they presumably qualify as commercial market participants because, among other reasons, they are eligible offerees of trade options.⁶⁴ A producer of one commodity is not a commercial market participant with respect to another commodity unless it is a different grade of the same commodity or a closely related commodity.⁶⁵ Moreover, persons who acquire physical commodities solely for investment purposes are not commercial market participants and, therefore, are not eligible for the forward contract exclusion.⁶⁶

More good news/bad news. The CFTC also provided guidance about contracts with embedded options in the final definition of swap. "Forward" contracts that fail any of the CFTC's multiple embedded options tests are either swaps or trade options.

The three-part test for embedded pricing options follows the guidance originally provided by the CFTC's General Counsel's Office in 1985. A forward contract with an embedded commodity option affecting price will be considered an excluded forward contract if the embedded option:

• may be used to adjust the forward contract price, but does not undermine the overall nature of the contract as a forward contract;⁶⁷
• does not target the delivery term, so that the predominant feature of the contract is actual delivery; and
• cannot be severed and marketed separately from the overall forward contract in which it is embedded.⁶⁸

Most forward contracts with embedded pricing options will pass the test unless the optionality can be marketed separately from the forward contract in which it is embedded. For example, a contract that (1) includes a separate premium for a financial "hedging" option, (2) refers to financial hedging options as separate "positions"; and (3) allows separate settlement of the financial option, may be closer to (or cross over) the severability line than one which makes all price adjustments in a monthly invoice and exclusively settles via physical delivery.⁶⁹

The CFTC announced a new seven-part test for embedded volumetric options, but requested additional comments from the public on this test.⁷⁰ There are several odd aspects and one troubling aspect to this test. First, it is unclear why this test has seven prongs since several appear to be subparts of the three-part embedded price option test. Second, the seventh prong—the requirement that the exercise or non-exercise of the embedded volumetric optionality be based primarily on physical factors or regulatory requirements that are outside the control of the parties and are influencing demand for, or supply of, the commodity— is particularly problematic. Commercial commodity market participants include volumetric optionality in physical delivery contracts for a host of legitimate commercial reasons. For example, a natural gas utility with a distribution system may have a supply contract for a base-load quantity with volumetric optionality that allows the utility to procure additional supply (for heating in cold weather, etc.). The utility may desire to have additional suppliers for certain quantities of natural gas, and those contracts may have volumetric optionality as well. If the utility exercises the option based on price alone, it would fail the seventh prong. If, however, the utility exercised the same option because it was the last natural gas available under its contracts (and the utility has an obligation under state law to serve its retail customers), it could be argued that the utility did so pursuant to a regulatory obligation outside of its control. From a commercial perspective, it is impractical to base regulatory treatment of the same gas supply contract on the reason why the party exercises the volumetric optionality. Further complicating the analysis, a supplier is not always in a position to know (absent contractual representations for example) the basis upon which the utility is deciding whether to exercise its volumetric optionality. It is unclear why the CFTC is concerned about or, even has jurisdiction over, contracts that settle via physical delivery even if the quantity delivered is within the control of the party exercising the volumetric optionality.

Not content with two embedded option tests, the CFTC also announced a three-part test for so-called "usage" agreements (the "Facilities Test").⁷¹ "Usage" agreements are physical commercial agreements for the supply and consumption of energy, such as tolling agreements, natural gas transportation agreements and natural gas storage agreements. If the usage agreement passes the CFTC's Facilities Test described below, then it is considered a forward contract, rather than an option or swap:

• the subject of the agreement is the usage of the facility rather than the purchase of the commodity (the "usage prong"),
• the buyer has an unconditional right to the exclusive use of the facility or part thereof (the "exclusive use prong"), and
• the payment is for the use of the facility rather than the option to use it (the "single payment prong").⁷²

This test had a number of very adverse, possibly unintended, consequences. The infamous "however" paragraph in the swap definition preamble, which attempted to explain the single payment prong of the Facilities Test, said, essentially, that usage agreements with two-part pricing were options, not forward contracts.⁷³ The problem is that FERC Order No. 636 requires certain interstate storage and pipeline transportation agreements to include separate reservation and usage rates. Thus, under the CFTC's usage agreement test, many interstate storage and transportation contracts appeared to be trade options, at best, or swaps, at worst. The CFTC's Office of General Counsel then issued a five part test "interpreting" the three-part usage contract test. Oy Vey! Under the five-part interpretation, the use of a two-part fee structure (for fixed costs, on the one hand, and variable costs, on the other) in a facility usage agreement should not cause the agreement to fall within the definition of "swap" (so long as it otherwise satisfies the three-part Facilities Test) if:

1. A facility usage agreement, contract or transaction ... includes a two-part fee structure;
2. The right to use the specified portion of the facility for the term of the agreement is legally established upon entering into the agreement;
3. The party who has legally established the right to use the specified portion of the facility for the term of the agreement pays the demand charge or reservation fee in a commercially reasonable timeframe;
4. The use of the facility does not depend on the further exercise of an option; and
5. The usage fee is in the nature of a reimbursement for the variable costs incurred by the operator of the facility in rendering the service.⁷⁴

This solved much of the problem with firm transportation and storage agreements, but it left unclear how to treat storage and transportation contracts with market-based rates, as opposed to the variable and fixed cost fee structure that the FAQ guidance addresses.

Book-Outs and The Brent Interpretation

For commercial convenience and to reduce operational costs, parties transacting in the electric power and natural gas forward markets routinely use "book-outs" to settle physical delivery obligations. The FERC has clarified that a book-out occurs "when the cumulative effect of a number of separate power sales between two parties is such that they mutually agree to exchange their obligations to physically deliver power to each other, while maintaining all their other obligations, including payment."⁷⁵ Booked-out power sales must be reported to the FERC, since the underlying transactions typically are for wholesale sales of electric energy. In contrast, purely financial transactions are not reported to the FERC.

In 1990, the CFTC issued the Brent Interpretation, which concluded that the 15-day Brent crude oil contracts were forward contracts excluded from the definition of futures contracts, notwithstanding that parties could forgo physical delivery and settle financially through an individually-negotiated agreement referred to as a "book-out."⁷⁶ The Brent-Interpretation noted that:

Under this scenario, the contracts represented a binding obligation to make or take delivery without providing any right to offset, cancel or settle on a payment-of-differences basis. The parties entered the agreements knowing that they might be required to make or take delivery. With these conditions in place, the Brent Interpretation determined that the contracts were forward contracts and not futures contracts.

The CFTC recently clarified in the Swap Final Rule that the principles underlying its Brent Interpretation related to book-outs that apply to the forward exclusion from the definition of futures also will apply to the forward exclusion from the swap definition for nonfinancial commodities.⁷⁸ Thus, book-outs for all nonfinancial commodities that satisfy the conditions in the Brent Interpretation do not affect the characterization of a forward contract under the exclusions from the definition of the term "swap" and the definition of "future delivery" in the CEA.⁷⁹

In light of its decision to expand the Brent Interpretation to apply to all non-financial commodities (previously this only applied to certain crude oil contracts), the CFTC elected to withdraw its 1993 "Energy Exemption," which extended the Brent Interpretation to energy commodities other than oil.⁸⁰ The CFTC also clarified that a physical netting agreement (such as the one in section 6.8 of the EEI Master Agreement) allowing for the reduction to a net delivery amount of future, unintentionally offsetting delivery obligations, is consistent with the Brent Interpretation, so long as the parties had a bona fide intent to make or take delivery when entering into the transactions.⁸¹ Finally, the CFTC announced a new "requirement" regarding the documentation of book-out transactions. The Commission stated that "in the event of an oral agreement, such agreement must be followed in a commercially reasonable timeframe by a confirmation in some type of written or electronic form."⁸² We view this "requirement" as in the nature of an evidentiary safe harbor. In other words, written documentation of an oral book-out makes it easier to prove that the book-out was a later, separate transaction from the original forward contract. It does not apply to book-outs that are documented with an instant message or e-mail.

Trade Options

In our 1999 article, we noted that many electric power market participants did not realize that the CFTC has jurisdiction over the purchase and sale of options on electric power. In fact, OTC options on electric power or natural gas must be offered and sold in accordance with the CFTC's "trade option" regulation. The Dodd-Frank Act had a significant impact on the CFTC's jurisdiction over trade options. First, the term "option" is expressly included in the definition of swap.⁸³ Second, in its Commodity Options Rule, the CFTC amended the trade option rule to conform with the statutory exemption from the definition of commodity. An option qualifies for the trade option exemption if:

1. Both parties intend that the commodity option be physically settled, so that, if exercised, the option could result in the sale of an exempt or agricultural (i.e., nonfinancial) commodity for immediate (spot) or deferred (forward) shipment or delivery;
2. The offeror (i.e., the seller) of the commodity option is ether (a) an eligible contract participant ("ECP"); or (b) a producer, processor, or commercial user of, or merchant handling the commodity which is the subject of the commodity option transaction, or the products or by-products therefor; and offering or entering into the transaction solely for purposes related to its business as such; and
3. The offeror must have a reasonable belief that the offeree (i.e., the buyer) of the commodity option is either (a) a producer, processor, or commercial user of, or merchant handling the commodity which is the subject of the commodity option transaction, or the products or by-products therefor; and (b) entering into the transaction solely for purposes related to its business as such.⁸⁴

An option transaction that does not comply with the CFTC's Commodity Options Rule exposes a party to a variety of regulatory risks. First, such a transaction may be a swap and, therefore, a swap dealer would have needed to comply at the time of the transaction with all of the CFTC's rules applicable to swaps. Second, a market participant that is not a swap dealer may need to treat the transaction as a swap for purposes of tracking whether it remains below the de minimis threshold, above which it must register as a swap dealer. Finally, it may expose a market participant to a CFTC enforcement action for failure to comply with regulations applicable to swaps.

The CFTC's Commodity Options Rule is imprecise and can be difficult to apply to actual transactions. One practical problem is identifying the "offeror" and the "offeree" of a particular option. This is important because a party's status as an offeror or offeree has an impact on the purposes for which they can use trade options. Although the CFTC has never defined the terms "offeror" or "offeree," the offeror generally is the grantor or the writer of the trade option.⁸⁵ The offeree generally is the party that pays the premium in exchange for the right, but not the obligation, to purchase or sell the commodity underlying the option.

The only restriction in the CFTC's Commodity Options Rule on who can offer trade options is that they be an ECP. As a result, the offeror of a trade option need not be a commercial party. Moreover, the CFTC's trade option rule does not limit the purposes for which the offeror may write and sell trade options. Thus, the offeror may sell a trade option for any purpose, including speculation on the price of the underlying commodity provided that it intends to deliver or take delivery of the commodity if the option is exercised.

Qualified Offerees of Power and Gas Trade Options

A commercial producer or user of electric power or natural gas, such as a utility, a manufacturing plant or other commercial business, is a qualified offeree of an electric power option under the CFTC's Commodity Options Rule. To the extent that utilities and other commercial entities purchase and sell options on power beyond the quantity they need in their commercial operations, they may qualify as "merchants," i.e., commercial entities that buy and sell commodities for the purpose of making a profit.

The Business Purpose Test

The CFTC's trade option rule requires that the offeree of the option enter into the option "solely for purposes related to its business as such." The precise meaning of this limitation remains unclear. The CFTC has identified hedging exposure to price changes and inventory management as permissible uses of trade options.⁸⁶ The CFTC has emphasized repeatedly that offerees of trade options cannot enter into those transactions for speculative purposes.⁸⁷ This suggests, for example, that a utility in its role as a "commercial user" cannot buy call options on a quantity of natural gas that exceeds the amount it needs to hedge its natural gas price risk or to have adequate inventories of natural gas. When a utility or marketer is the offeror of a trade option, the business purpose test does not apply to it, but it does apply to its counterparty.

WHAT'S NEXT?

Much has changed over the last 14 years, but regulatory uncertainty remains a constant. Congress appears to prefer ambiguous jurisdictional lines and regulatory overlap. The CFTC and FERC have new anti-manipulation authority and, notwithstanding the D.C. Circuit's decision in Hunter, market participants can expect both agencies to use their authority aggressively. If it ever materializes, the MOU between the commissions (required under the Dodd-Frank Act) may draw some lines, bright or dim, in the enforcement context.

From a regulatory perspective, the RTO/ISO exemption order, once final, will provide market participants with greater certainty about which agency will regulate the markets, transactions, and participants in organized wholesale electricity markets. Unfortunately, when it comes to bilateral power and natural gas transactions, market participants will continue to have to discern the lines between the agencies' regulatory authority from the text, preambles and interpretations of their respective regulations. If anything, the Dodd-Frank Act seems to have expanded the scope of the CFTC's regulatory authority over transactions that many market participants probably viewed as within the FERC's purview.

In sum, there are two things that market participants can take as constants: Congress is highly unlikely to resolve these jurisdictional ambiguities and squabbles, and the two agencies are unlikely to cede jurisdiction or blink. As a result, commodity and derivatives lawyers continue to find themselves on a journey in a dark forest for the straightforward regulatory path has been lost.

Originally published in The Futures & Derivatives Law Report Vol. 33 Issue, February 2013.

Footnotes

1. The authors are members of the Energy and Commodities Practice Group at Cadwalader, Wickersham & Taft LLP.

2. Dante, Inferno (Matthew Pearl ed., H enry W. Longfellow trans.) (2003).

3. Paul J. Pantano, "Electric Power: Managing Legal Risk in a New Commodity Market," Futures & Derivatives Law Report at 1, Apr. 1999 (citing Energy Information Service, The Changing Structure of the Electric Power Industry: S elected issues, 1998, DOE/EIA-0562, July 1998).

4. CEA § 2(a)(1)(A), 7 U.S.C. § 2.

5. CEA § 4(a), 7 U.S.C. § 6(a).

6. CEA § 1a(27), 7 U.S.C. § 1.

7. 7 U.S.C. § 1a(47)(B)(ii).

8. Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Final Rule, 77 Fed. Reg. 48208 (Aug. 13, 2012) ("Swap Final Rule").

9. See, e.g., CFTC, Regulation of Noncompetitive Transactions Executed on or Subject to the Rules of a Contract Market, 63 Fed. Reg. 3708, 3712 (Jan. 26, 1998); Bank Brussels Lambert, S.A. v. Intermetals Corp., 779 F. Supp. 741, 748 (S.D.N.Y. 1991).

10. 17 C.F.R. § 32.4(a).

11. 42 U.S.C. § 7171.

12. 16 U.S.C. § 824.

13. 42 U.S.C. § 7172(a)(1)(B).

14. 16 U.S.C. § 824o.

15. 16 U.S.C. §§ 824b, 824c, 824d(b).

16. 16 U.S.C. § 824d(c).

17. 16 U.S.C. § 824d(a).

18. Id.

19. 16 U.S.C. § 824d(b).

20. See New York Mercantile Exch., 74 FERC ¶ 61,311 (1996) (holding that electricity futures contracts approved for trading by the CFTC were not securities as defined in section 3(16) of the FPA and, therefore, not within the FERC's jurisdiction under sections 203 and 204 of the FPA but finding that such a contract is subject to FERC jurisdiction under sections 205 and 206 of the FPA if it "goes to delivery, the electric energy sold under the contract will be resold in interstate commerce, and the seller is a public utility").

21. Id. at n.2.

22. Puget Sound Energy, Inc., 96 FERC ¶ 63,044, at 65,381-382 (2001).

23. See Puget Sound Energy, Inc., 103 FERC ¶ 61,348 (2003) (declining to order refunds on other grounds).

24. Revised Public Utility Filing Requirements, Order N o. 2001, 99 FERC ¶ 61,107 at P 281 (Apr. 25, 2002).

25. Revised Public Utility Filing Requirements, Order N o. 2001-F, 106 FERC ¶ 61,060 at P 15 (Jan. 28, 2004).

26. DC Energy, LLC v. PJM, 138 FERC ¶ 61,165 at P 66-67 (2012) (finding that "IBTs [Internal Bilateral Transactions] must have the potential for a physical transfer of energy to offset the deviation created by transactions in the day-ahead market" and that DC Energy's "IBTs merely represent a transfer of financial liabilities, with no intent or prospect of a physical transfer of electric energy, notwithstanding their use of the ISDA M aster Agreement and Power Annex").

27. Id. at 69 ("Complainants have no capability to handle physical performance, as neither DC Energy nor DCE M id-Atlantic owns generation resources, is a load-serving entity, or acted as a marketer-intermediary by contracting with entities owning generation or having load-serving or other physical obligations. At no point did Complainants acquire title to physical energy, incur any network transmission charges, or make any reservations for point to point transmission capacity. Complainants' IBTs settled financially and were intended to settle financially.") (citations omitted).

28. See DC Energy, LLC v. PJM, Request for Rehearing of DC Energy, LLC and DC Energy Mid-Atlantic, LLC, at 79-81, Docket N o. E L12-8- 001 (Apr. 9, 2012).

29. 16 U .S.C. § 824v(a) ("It shall be unlawful for any entity (including an entity described in section 824(f) of this title), directly or indirectly, to use or employ, in connection with the purchase or sale of electric energy or the purchase or sale of transmission services subject to the jurisdiction of the Commission, any manipulative or deceptive device or contrivance (as those terms are used in section 78j(b) of title 15), in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of electric ratepayers.").

30. Staff Report to the Federal Energy Regulatory Commission on the Causes of Wholesale Electric Pricing Abnormalities in the Midwest During June 1998 at 4-5 (Sept. 22, 1998) (the "1998 FERC Staff Report").

31. Credit Reforms in Organized Wholesale Electric Markets, 133 FERC ¶ 61,060 (2010). In addition, the Committee of Chief Risk Officers ("CCRO") was established several years ago as a vehicle to establish and promote "best practices" in the field of risk management. Because its members are comprised of many energy and utility executives, risk management with respect to the energy industry has been a focus of the CCRO. To provide needed definition to the risk management requirements implemented through FERC's Credit Reform Order, the CCRO began an initiative—through a combination of RTO/ISOs and market participants alike—to prepare a set of recommended risk standards to use as a "baseline" for compliance. The CCRO's detailed recommendations were not "adopted" wholesale however. Instead, the RTOs/ISOs have incorporated a more generalized set of risk policy requirements, leaving the door open for additions in the future. These requirements are clearly guided by the CCRO's work and focus on such things as independent governance over risk management functions, adequately trained personnel, and having the necessary infrastructure in place to address risk. It will be interesting to see how these requirements develop going forward, especially as the various RTOs/ISOs make progress on "verifying" the adequacy their respective members' risk policies and procedures as directed by FERC.

32. ERCOT performs the role of the independent organization as an ISO subject to oversight by the Public Utility Commission of Texas ("PUCT") and the Texas Legislature. E RCOT was part of the exemption petition filed at the CFTC but, for convenience, this article refers only to the RTOs/ISOs.

33. Energy Policy Act of 2005, §§ 315, 1283 (codified at 15 U .S.C. § 717c (2005) and 16 U .S.C. § 824 et seq. (2005)).

34. See 18 C.F.R. § 1c.

35. See Prohibition of Energy Market Manipulation, Order N o. 670, 71 Fed. Reg. 4244 (Jan. 26, 2006), FERC S tats. & Regs. ¶ 31,202 at P 49 (2006) ("Order No. 670").

36. Id.

37. See Order N o. 670, FERC S tats. & Regs. ¶ 31,202 at P 22 (emphasis added).

38. Id.

39. EPAct 2005 §§ 316, 1281 (codified at 15 U .S.C. §§ 717t-2(c)(1) (2005) and 16 U .S.C. § 824t(c)(1) (2005)).

40. See Memorandum of Understanding Between the Federal Energy Regulatory Commission (FERC) and the Commodity Futures Trading Commission (CFTC) Regarding Information Sharing and Treatment of Proprietary Trading and Other Information, executed October 12, 2005.

41. The FERC stated that the two agencies are "working to finalize arrangements for information sharing between the two agencies." S ee California Independent System Operator Corporation, 142 FERC ¶ 61,069 (2013), n.8. It is unclear whether the FERC's statement is a direct reference to the MOU , or whether the other items beyond information sharing also are being addressed.

42. See CEA §§ 6(c); In re Sumitomo Corporation, 2 COMM. FUT. L. REP. (CCH) ¶ 27,327 at 46,499 (CFTC 1998) (finding that Sumitomo's conduct caused "distorted and artificial" prices in the U.S. cash market for copper).

43. See CEA § 6(c)(5), 7 U.S.C. § 9(5).

44. See Complaint, CFTC v. Amaranth Advisors LLC, et al., No. 07-CV-6682 (S.D.N.Y. 2007).

45. See Order to S how Cause and Notice of Proposed Penalties, 120 FERC ¶ 61,085 (July 26, 2007) ("OSC").

46. See OSC at P 48.

47. Hunter v. FERC, N o. 11-1477 (D.C. Cir. filed Dec. 12, 2011).

48. Hunter v. FERC, N o. 11-1477, slip.op (D.C. Cir. March 15, 2013) at 2.

49. Id. at 7.

50. Id. at 8.

51. Id. (Emphasis added).

52. Id. at 9. The court also held that nothing in Section 4A of the N GA (1) permits the FERC to "intrude upon," or (2) impliedly repealed, the CFTC's exclusive jurisdiction. Id. at 10 and 12.

53. FTRs will be exempt from all but the antifraud and anti-manipulation provisions of the CEA under the CFTC's proposed RTO/ISO exemption order. And, although RTOs and ISOs will be exempt from the designated contract market and swap execution facility provisions of the CEA, for purposes of determining which agency has exclusive jurisdiction over certain transactions in their markets, RTOs and ISOs arguably operate as exchanges or SEFs.

54. The CEA defines a commodity as broadly as certain enumerated agricultural products and "all other goods and articles ... and all services, rights, and interests ... in which contracts for future delivery are presently or in the future dealt in." CEA § 1a(9), 7 U.S.C. § 1a.

55. For example, in 1999, members of EE I collaborated to create the EE I M aster Power Purchase and S ale Agreement (the "EEI Master"), documenting essential terms governing forward purchases and sales of wholesale electricity. For natural gas transactions, the North American Energy Standards Board ("NAESB") created the N AESB Base Contract for S ales/Purchases of Natural Gas (the "NAESB M aster"), a base agreement providing standardized terms and conditions for physical natural gas purchase and sale transactions. The N AESB M aster enabled long-term gas transactions, unlike the Gas Industry Standards Board ("GISB") master agreement, which focused on short-term physical gas transactions.

A FERC-approved "umbrella agreement" for use by members of the Western System Power Pool ("WSPP") to transact physical power (the "WSPP Agreement"), governs the terms of purchases and sales by WSPP members, including utilities. Unlike other form master agreements, the WSPP Agreement is not bilaterally negotiated. Instead, entities automatically become a counterparty upon joining the WSPP. Because of this, members are subject to any changes to the WSPP Agreement passed by a majority of WSPP members and approved by the FERC. Similar to other master agreements, counterparties to the WSPP Agreement can also negotiate for the addition of special provisions through an addendum or transaction "confirm."

Finally, ISDA created a M aster Agreement with standard terms governing derivative transactions. The original ISDA M aster was created in 1992, but has been revised since then. In 2003, ISDA added a power annex incorporating terms and conditions consistent with the EE I M aster that were not previously addressed under the ISDA M aster. ISDA added a gas annex in 2004, also incorporating terms and conditions from the N AESB M aster not previously contemplated in the N AESB M aster. Master netting agreements are also available to mitigate credit risk.

56. Staff Report at 3-4.

57. See, e.g., In re The Andersons, Inc., CFTC Docket N o. 99-5, slip op. (Jan. 12, 1999) (CFTC Settlement Order finding that certain agricultural contracts denominated as forwards were illegal futures contracts); In re M G Refining & Marketing, Inc., CFTC Docket N o, 95-14, slip op. (1995) (CFTC Settlement Order finding that certain petroleum product supply contracts were illegal futures contracts).

58. CFTC investigations can disrupt a party's business operations and have an adverse effect on its relationships with its counterparties. Moreover, if the CFTC decides to initiate an administrative or federal district court enforcement action against the party, the potential sanctions include substantial civil penalties and disgorgement.

59. Swap Final Rule at 48229.

60. Id. at 48233.

61. Id. at 48237.

62. Id. at 48229.

63. Id.

64. Commodity Options, 77 Fed. Reg. 25320 (Apr. 27, 2012) ("Commodity Options Rule"). 65. Swap Final Rule at 48229, n.224.

66. Id. at 48229.

67. The CFTC noted that a forward with an embedded option with a formulaic strike price based on an index value that may not be known until after exercise would be a forward contract if it meets the rest of the three components.

68. Swap Final Rule at 48237.

69. In re Wright, CFTC Docket N o. 97-02, (CFTC Oct. 25, 2010) ("Embedded options may be used to adjust the forward price if they do not undermine the overall nature of the contract as a forward. If the option targets the delivery term and renders delivery optional then the 'predominant feature' of the contract cannot be actual delivery and the transaction fails to qualify as a forward.").

70. Swap Final Rule at 48238.

71. Swap Final Rule at 48242.

72. Id.

73. See Swap Final Rule at 48242 ("However, in the alternative, if the right to use the specified facility is only obtained via the payment of a demand charge or reservation fee, and the exercise of the right (or use of the specified facility or part thereof) entails the further payment of actual storage fees, usage fees, rents, or other analogous service charges not included in the demand charge or reservation fee, such agreement, contract or transaction is a commodity option subject to the swap definition.").

74. See Office of General Counsel Response to Frequently Asked Questions Regarding Certain Physical Commercial Agreements for the Supply and Consumption of Energy (Nov. 14, 2012), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/leaselike_faq.pdf.

75. Order No. 2001, at P 8, n.9 (Apr. 25, 2002).

76. Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (Sept. 25, 1990) ("Brent Interpretation").

77. Brent Interpretation at 39192.

78. Swap Final Rule at 48229.

79. Id. at 48229.

80. Id. at 48229-30.

81. Id. at 48230.

82. Id.

83. Swap Final Rule at 48349.

84. Commodity Options Rule at 25326.

85. See, e.g., Regulations Permitting the Grant, Offer and S ale of Options on Physical Commodities, 50 Fed. Reg. 10786, 10790 (1985).

86. See, e.g., CFTC Interp. Ltr. N o, 84-7, [1982-1984 Transfer Binder] COMM, FUT. L. REP. (CCH) ¶ 22,025 at 28,595 (984); Proposed Amendments Concerning Trade Options and Other Exempt Commodity Options, 56 Fed. Reg. 43560, 43561 (Sept. 3, 1991).

87. See, e.g., Regulation of Commodity Option Transactions, 43 Fed. Reg. 54220, 54221 (Nov. 21, 1978); Proposed Reissuance of and Amendments to Regulations Permitting the Grant, Offer and S ale of Options on Physical Commodities, 46 Fed. Reg. 23469, 23476 (Apr. 27, 1981); Policy Statement Concerning Swap Transactions, 54 Fed, Reg. 30694, 30695 n.14 (1989).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.